Cash is like air; profit is like food. You need cash all the time, but you can survive—for a while—without profit.
Certainly, profit is essential for a business to grow. If there is no profit being generated over the long-term, the business will see its original investment dwindle and new investors will stay far away. If the business is lucky, a buyout will occur; more likely, the company will disappear.
The flipside is also true: it is a fatal mistake to overlook your cash position. Cash is necessary for the short-term survival of the firm.
The danger of confusing cash and profit
When you’re profitable you tend to think in overly simplistic terms: “If I do twice as much of what I’m doing, I’ll make twice as much profit.” But the problem is that there will be a lot of cash going out for expansion—for buying equipment, leasing premises, hiring people, developing a finished good—and your cash might be gone before any new money comes in.
That transition when a company is expanding and also expending is perhaps the most dangerous time in business. Financial commitments come up, the company can’t raise enough funds, and it has to sell something at a loss to raise cash…winding up in a worse position than at the beginning.
Entrepreneurs, especially high-tech startups, have to prepare for the dangerous period to be extend beyond their initial projection. They must recognize that they will pump lots of cash into R&D and the startup costs of building something that has be large-scale in order to make a profit.
At Income|Outcome, we see this “cash vs. profit” scenario play out firsthand. When we bring on a new client, we have to pay a lot of expenses associated with training that client. We have to pay for consultants, printing, and travel costs, and we are obligated to pay people within 30 days if they’ve done work for us.
One particular client doesn’t pay for six months. It’s a profitable sale, but we’re not seeing that cash (and those profits) coming in for quite awhile. Meanwhile, we have all the expenses associated with that relationship. It’s very painful, but in effect it’s a consequence of expansion.
We have to make sure we have a strong enough cash flow to stomach the interim period while we’re waiting to be paid. Otherwise, our profits are a dream that won’t be realized.
Cash vs. profit played out numerically
Let’s put some very round numbers on things. Suppose you’re making sales of $100, and you burn up an inventory of $50 and have other expenses of $40. This leaves you with $10 as profit. You’re pleased; you’re running a profitable business, and you think if you double everything you’ll make twice as much.
However, in order to make a sale, you’ll also need a larger inventory. Currently, you have an inventory worth $200 and you’re making sales and using $50 of that inventory in the sales. Now, for the larger sale, you have to put another $200 in to have twice as much inventory, you may have to rent some additional space to store it, and you may need to spend more on finding clients…. and the money for all that goes out before you’ve made any additional sales.
Your sales might go up to $200, but your cost of sales increases to $100. Your profits may be double or more, but the money you had to pay for extra inventory and to recruit and train salespeople and any other costs has increased and gone out months before you start selling—not to mention the fact that some people don’t pay until months after a sale.
How to pay attention to both cash and profit
Avoiding a critical oversight of either cash or profit requires multiple things.
1) You need a strategic plan
Where do you want to go? Where would you like to be at? This is the “dreamer” or vision phase of business planning; it’s necessary, though certainly not enough to fuel a business.
2) You need a budget
Use a budget from your income statement to measure past profit and project it forward into the future. You must determine whether the business can be profitable before your ever worry about cash flow. Without profit, a business will never survive long-term.
You can use your P&L from the last six months to determine a budget for the next six months.
3) You need a Cash Flow Forecast
Budgets tell you if your expansion will be profitable, and how much profit you will make. But they don’t tell you when cash is coming in. That’s where the cash flow forecast comes in.
Once you have a grasp on how to handle your cash flow needs, a) your own expectations will be as realistic as can be, and b) banks and investors will look more favorably on your business. They will know they’re dealing with someone who understands business and isn’t just a dreamer.
You should be looking at least a year down the road, to know when and where money is going out and where it will come in from. That way, you’ll know how much money will have gone out before your profitable sales start. It’ll tell you how much fresh funding you’ll need beyond the profits of the business and when you can afford to start your expansion if you’re going to self-fund.
If you find there’s no way you can find the cash you need, you’ll have to go back and revisit your plans. Repeat each step until it works.
The bottom line: cash is not profit, and profit is not cash. You need both to sustain and grow a business, though not in equal measures at every point.
But you never start with the cash flow. The vision starts a business, profitability helps it grow, and cash flow is the day-to-day driver.
As long as you have enough cash to survive, you can comfortably expand to a more profitable business. You won’t succumb to panic when the expansion takes longer than you thought, and you’ll eventually reap the benefits of greater and greater profits.